CDOs and CDSs contribution to the Financial Crisis

February 29, 2016

By Zenobia Sethna.

CDOs caused $542 billion in of the write-downs of banks, while the market size of CDSs peaked at $60 trillion. Simply put, a CDO is a fancy bond entered into in order to reduce the derivatives position credit risk and counterparty risk, while a CDS is mostly an insurance policy, in this case taken to cover the CDOs.

Here’s an account of how CDOs and CDSs brought down the US economy.

Synthetic CDOs and CDOs-squared off were far removed from homeowners. However, their foundations rested on homeowners making regular mortgage payments.

In 2005, a rash of subprime mortgages were issued with two-year teaser rates. These rates were around 4 to 6%, and would jump to 10 to 15% in a couple of years.

When teaser rates were low, a lot of people bought houses. These purchases were via loans offered beyond the means of the borrowers. They even contributed purchasing of a second or third house purely as an investment. The people who were at risk of not making their monthly payments put the subprime in subprime mortgages.

Teaser rates were low in 2005, and mortgage lenders jacked up these rates in 2007. Suddenly, when interest rates increased, homeowners were no longer able to make mortgage payments.

When individual mortgages started to fail in record numbers, the mortgage bond they made up got in worse health. Consequently, its tranches followed. This domino effect ensured, the CDO, which is made up of the riskiest tranches of mortgage bonds, started to go down. Suddenly, the CDOs that were rated A, AA, and AAA which were supposed to be low risk started to fail.

When the CDOs started to collapse, the CDS contracts were triggered. The hedge funds that bet against CDOs found that their bets had paid off.

The banks (including Lehman Brothers, Merrill Lynch, and J.P. Morgan) and the insurance companies (including AIG), all either owned CDOs or sold credit default swaps. They found that their CDOs had failed, and were on the hook for billions of losses because they bet wrong.

Dozens of banks failed, the most high-profile of which are Lehman Brothers and Bear Sterns. AIG declared bankruptcy. Merrill Lynch was sold to Bank of America. People started to panic, and credit markets seized up. Businesses struggled to keep their loans and get new ones.

It was at this time that Congress passed TARP, the Troubled Asset Relief Program, a $700 billion bailout of the big banks and the insurance companies..

Meanwhile, the hedge funds that saw the crisis coming made billions, as talked about in financial courses in India.

How do the CDOs and CDSs fit into the financial crisis?

It’s important to note that the subprime mortgage crisis is only one part of the general financial crisis. However, the deepest recession since the Great Depression had many causes. The collapse of the mortgages precipitated a run on the shadow banking system in 2007, which some economists argue are the main reason that the financial crisis has hurt as much as it did.

The IMDP scheduled on 21st and 22nd of March, 2016 conducts an in depth analysis of these derivative instruments and other structured finance products by industry expert Rajat Bhatia.

Imarticus learning is an institute that provides financial analyst courses, business analytic courses, big data training, CFA courses in India, these are classroom and online finance courses that allow users to learn at their convenience.